Inventory Management and Cash Flow for e-Commerce
October 8, 2007, Ted Hurlbut appeared on Product Sourcing Radio with Colette Marshall to discuss ways e-Commerce Retailers can improve cash flow.
Here's an edited transcript of Ted's appearance.
CM: Part of successful product sourcing is understanding how much inventory to source and how often. A lack of inventory planning will result in surplus merchandise, forced discounts, and lost profits. Today we're talking to Ted Hurlbut, Principal of Hurlbut and Associates, who will be sharing some of the good practices he's learned in his more than 25 years of experience in retail inventory management.
CM: Ted, welcome to the show.
TH: Thank you for asking me to be on the program.
CM: It's wonderful to have you on. We know inventory management for many online retailers is a big concern and it's something online retailers should really understand. How significant an issue is inventory management?
TH: If you think about the structure of a retail e-commerce business and you think of it from a financial perspective, in terms of the Balance Sheet, inventory is the biggest asset. It ties up the biggest chunk of cash. It tends to consume cash very easily. Inventory is also what I call the active asset. Among all the assets that an e-commerce retailer may have, inventory is going to be the one that generates the sales, that generates the gross margin dollars, that generates the profit. When an ecommerce retailer gets into trouble, inventory is often the source of the trouble, with cash starting to get tight. Often when cash is tight you see situations where there simply is too much inventory and it's robbing the business of the flexibility that it needs financially, but also operationally, to do the things that it needs to do to grow the business.
CM: That's such a great point, and I'm sure there are many retailers out there who could definitely benefit from learning a little bit more about inventory management. Many may think that inventory is a good thing, however. They might say you can't do business without it. But you seem to be saying that too much inventory is a bad thing.
TH: Absolutely. It ties up a lot of cash, as I mentioned, but it also starts to erode a lot of other business fundamentals. Too much inventory, when it hangs around and gets shop worn, and starts to run up against the end of a particular selling season, only leads to increased markdowns. And markdowns really rob an ecommerce retailer of gross margin dollars. Gross margin dollars are those critical dollars that are needed to pay the bills and to grow the business. But there is a longer term, more insidious impact as well, and that is that it begins to destroy price integrity and it robs customers of a sense of urgency about the business. Customers are pretty smart and they come to understand that when there's a lot of inventory and they see a lot of markdown activity, that inventory is not going anywhere. They learn that they don't need to respond immediately, that if they wait you out the price will come down. What you end up doing is trading earlier, fuller margin sales for later markdown sales where you may be selling the unit, but you're not generating as much cash for that unit as you might have otherwise earlier. Inventory is what I call a necessary evil. In any ecommerce retailer or retailing environment you've got to have it to do business, unless you can find some way to drop ship everything directly from your manufacturers, which in most cases is not workable. Too much inventory can really begin to erode business fundamentals as time goes along.
CM: Right. For the retailers out there listening, market research is key. When you identify what kind of products to sell, getting an idea of how fast that product is going to sell will give you an idea of how to control your inventory so you don't have issues of inventory turnover, and always having to consider that gross margin.
CM: What are some of the critical tools a retailer needs for managing inventory?
TH: In working with my clients the two basics that I like to make sure are in place are a Cash Flow Plan and an Open-to-Buy plan. The reason that somebody might call me and ask for assistance is they're finding that their inventory is getting heavy or their markdowns are getting to be a little bit out of control, or they are tight on cash. But it all starts with cash. As I said earlier, inventory chews up a large portion of an ecommerce retailer's asset base, so it's important to understand what's going on with that cash. And a Cash Flow Plan takes into account the big picture of what's going on in the business from a cash perspective, not just the inventory. The Open-to-Buy really is about managing a subset of that cash flow, it's managing the expenditures for inventory.
CM: Can you expand on that a little bit more?
TH: Let's talk a little bit more in-depth about a Cash Flow Plan, because I really do think it's important. A Cash Flow Plan is basically a rolling budget, sometimes it's called a roll forward budget. You start with the current cash balance, then add in your planned receipts, the cash coming into the business from sales. From there, you establish budgets for all of the businesses expenditures, whether it's expenditures to pay for product, payroll, utilities, and any other expenditures. At the end of the month (or the week in some larger organizations) you've got a projected ending cash balance. In the course of creating a cash flow plan you can see exactly where your projected shortfalls are. You'll have also established a series of benchmarks so that as you go forward you have a means of measuring where you are falling short, where you are making your budget, you have visibility to if you are projected to fall short at the end of any months.
CM: That's such a great point. That's how you can identify the times of the year when you can maybe change what you're selling on your site, because you need that to generate more cash flow.
TH: Often when the Cash Flow Plan is not coming in, when they're deviating from the plan, it's because of expenditures for inventory are coming in above plan. A Cash Flow Plan is one tool for quickly identifying that the payables for inventory are getting a little bit out of control. There are things that can be done, you can negotiate extended terms or actually cut back on stock levels. The Open-to-Buy plan helps you identify if you're bringing in too much inventory, and specifically where that inventory is getting a bit heavy. Strictly from a cash flow perspective, a Cash Flow Plan helps you manage the payables piece, and identify if cash is projected to get a bit tight or even projecting to turn . It identifies at an early point, when you have the most leverage with your vendors, that there's a problem, so that you can try to get extended terms, extended dating, whatever it might be, in order to get yourself back into an appropriate cash position.
CM: You mentioned again Open-to-Buy. Can you go into a little bit more detail on how this works?
TH: It's also a very important tool. At a high level, an Open-to-Buy is something that's specifically related to retail merchandise. It's something that specifically addresses the needs of retailers. It's a budget that's future oriented, provides guidance on how much to buy, and provides benchmarks. And it is a financial tool. Usually Open-to-Buys are denominated in retail dollars as the unit of measure. Very rarely do you see it denominated in units. Sometimes you see it in cost dollars. But most of the time it's in retail dollars, and because it is a financial budget it does relate back, indirectly, to a cash flow plan and to the financial performance of the company. It's also something that's dynamic. An Open-to-Buy typically is maintained at a department classification or sub-classification level.
CM: This sounds like a great tool that's designed to assist retailers in managing and replenishing their inventory investment, giving them the ability to decide when is it better to order more product, and when they need order less, and be able to manage their cash flow. Can you go into a little bit more detail about Open-to-Buy?
TH: First, I think there is an important point to be made here, and that is that category management, even for an ecommerce retailer, is very important. As ecommerce retailers are establishing websites they are developing a brand identification from a consumer's perspective and it's important to understand that from a consumer's perspective. Consumers come to expect that certain products, certain categories of merchandise, are going to be available at that website. So it may not be that they're necessarily looking for specific items, but they are there because they recognize that website is a place to go for dresses or curtains or whatever the product category may be. The concept of category management and segmenting your business into those critical categories and managing your inventory by those classifications is just as valid for an ecommerce retailer as it is for a bricks-and-mortar retailer. How does an Open-to-Buy work? Well, like any budget it starts with a plan. Planning is the first critical step, and one of the things I believe is that those that take the time to do the planning are going to find that they're far more successful than those that don't. Frequently, especially in smaller operations, there's a sense that there isn't time to plan or planning is not as important, but it is just as important. And an Open-to-Buy, to really make it work, has to start with planning. The first thing you want to plan is sales, and in most cases you're planning sales by month. The critical question is, what's the most likely level of sales we're going to achieve, by month? There's an important point here, because I said the question is what is the most likely level of sales. What you're really asking is what's the level of sales that has the highest probability of occurring. Let's say my answer is 100. That doesn't mean that I might not sell 99 or 98 or 101 or 102, but the most likely level is 100. I could also sell 110.
CM: Ted, do you mean the level of sales for that category or the level of sales overall?
TH: That's an important question. If you are, in fact, breaking down the Open-to-Buy into a given category, then that question would be asked at the category level. The planning you're doing is at that level that you've broken your business down into. Let's say your business is made up by ten discrete categories that you've identified, you're going to want to plan each of those categories.
CM: So in other words, make an Open-to-Buy type scenario for each of those categories.
TH: The beginning of the process is determining what's the most likely quantity that I'm going to sell. Not the most that I possibly could sell, but what's the most likely level of sales for that period of time.
CM: I nice conservative number.
TH: Well, again, most likely. What's the highest probability. Often, both retailers and ecommerce retailers get in trouble because they focus on what's the most they possibly could sell.
CM: I see. And then once you've done that, what is the next step in developing your Open-to-Buy plan?
TH: The next piece of it is to determine an inventory plan by month for each of the categories that you're planning. The critical question to ask is how much inventory do I need at the end of each month to support the next month's planned level of sales. In some cases you may need to have a little bit more than one month forward, you may want to plan for the next couple of months of sales. But the critical question is how much inventory do I need at the end of each month to support the future sales? And then from there you're able to determine how much inventory you're going to need to bring in, what your merchandise receipts will. If you know what your beginning inventory is for a given period, for instance, and you know what you expect to sell in that period and you know what you want to end with in that period, you can calculate from there how much you need to bring in to support those sales and that ending inventory. And that's the critical thing that we're trying to get to. Many smaller independent retailers, ecommerce retailers, will initially look at the receipts and say, what do I want to bring in, but they haven't started at the beginning of the process by asking themselves how much they expect to sell and how much inventory they need to have on hand to support those sales? Those are the two questions that really drive the how much to bring in. And once you have that by category by month, you have a purchasing budget. If you're doing this pre-season, when all good planning should be done, you can go into the market and you know on a monthly basis, by category, in retail dollars, what you need to be buying and slotting for delivery into those periods. It helps you flow your inventory. It assures that you don't have too much inventory too early in a season that could back up on you and create some markdown pressure. An Open-to-Buy really does answer the question, how much do I need to bring in and when do I need to bring it in? In addition to that, it gives you a good indication of when the payables are likely to come due for the inventory coming in each month, maybe thirty days out, maybe sixty days out, which gives you numbers that you can plug into your cash flow plan as well.
CM: That's good. The other thing it does for you is if you have a long lead time with your suppliers and you know that lead time and you know what that projection is going to be, you can plan much more accordingly.
TH: Well I'm a big believer that if you are operating a seasonal business, and most businesses do have some seasonality to them, that as soon as the season ends that's when you should be planning for the next season, for a couple of reasons. First, that's when your experience from the prior season is most fresh in your mind. Second, for those things that have the longest lead times it gives you the opportunity at a very early stage to know what you want to do going forward, so that when you're dealing with those vendors that do have longer lead times you are dealing from a plan as opposed to dealing a little bit more from the seat of your pants. So I do recommend trying to put your plans together for a season as soon as that prior season is just completed.
CM: That's great advice. What about new entrepreneurs who are just getting started and they don't really have a prior season to work from, do you recommend continually going into that Open-to-Buy plan and making adjustments based on the current information they have?
TH: Even for somebody that's just starting out I think that it's important to try to craft a plan as best as you can. Vendors oftentimes can be a valuable source of information. You can't count on them to do your planning for you, but they can provide you guidance as to how much you should expect to sell, how quickly you can expect to sell, what month it might be most saleable in. One of the key things a plan does give you is a series of benchmarks and as you get into a season, whether you're established or whether you're new starting out, it's important to have those benchmarks so you can evaluate your progress. You're able to compare planned sales versus actual sales, planned ending inventory versus what you actually did end with, what you planned to bring in for inventory receipts versus what actually did come in. Whether you're just starting out or whether you are established, having those series of benchmarks going into the season, having done that planning, is critically important so that once you do get into the season you've got some basis for making decisions and managing your inventory. Those benchmarks will help you prevent inventory from building up and pushing you into a place where you're going to have excessive markdowns and you're going to start seeing your margins erode.
CM: Are there any existing systems that have Open-to-Buy functionality already incorporated into them?
TH: Some retail software packages have Open-to-Buy modules as an add-on option. There are very few where it's part of the core package, especially for smaller, more entrepreneurial type of retailers or ecommerce retailers. They do struggle with this because they don't have the functionality in their systems. Larger retailers have this functionality, and more, to manage their inventory. For many of my clients I find the most cost effective solution, both for a Cash Flow Plan as well as for an Open-to-Buy is to develop something off-system on a spreadsheet. It's not that complicated to do and for a lot of my clients that's exactly what I do for them.
CM: Good ol' Excel.
CM: For my personal site I swear I use Excel for nearly everything.
TH: Well you know, the great thing about it is that no two businesses are alike, so their needs from an Open-to-Buy basis are never alike and for smaller, independent retailers, ecommerce websites, having the capability to tailor something to their specific need is critical to really making the tool work for them.
CM: What about other critical metrics that a retailer should keep an eye on, beyond sales and inventory levels?
TH: I think the one great overlooked metric is gross margin, both gross margin percentage and gross margin dollars. Gross margin dollars is the lifeblood of any retail business, ecommerce or storefront. It's those dollars that are available after you've paid the vendors to pay for all the other things, whether it's advertising or payroll or utilities, whatever it may be. I've had clients who were concerned about sales, but we've focused on margin, and I point out to them, that though sales might have been soft in given period, look at all the additional gross margin dollars you generated, and suddenly they're starting to realize that what they thought was a soft period really had been pretty good because they generated a lot more gross margin dollars than they had in the prior year.
Gross margin as a percentage metric is very important as well because that's a function of what your initial markups are, as well as the markdowns you're having to take in order to move product through. Your gross margin dollars can be improved by trying to find opportunities to get additional markup as well as by trying to manage your inventory a little bit tighter so that you don't have that markdown erosion.
CM: So how about some other terms that we've heard like inventory turnover, gross margin, return on inventory investment? There are so many keyword terms in this subject.
TH: There certainly are. These are critical metrics for measuring how well inventory is being managed. And even for smaller businesses these types of metrics can be very illuminating and help people really understand how they're doing. The key to any retailer's success is to turn their inventory into cash at the best possible markup as quickly as they can and then buy more inventory and turn that into cash as quickly as they can. It sounds sort of simple, but at the core that's really what the mission is. And implicit in that kind of a statement is the fact that turning your inventory over as quickly as you can is critical to keeping the inventory fresh and keeping the cash flow coming. So inventory turnover is pretty straightforward, it's how many times was I able to turn my inventory during the year into cash, buy more and turn that into more cash.
The basic calculation there is to take the sales during the course of the year at the retail value and then take the average inventory and divide the sales by the average inventory. You derive the average inventory by looking at the ending inventories for each of the months. You use both sales and average inventory at retail value. In some cases you need to do it on a cost basis, the cost of the inventory that you sold versus the average inventory value it cost. But basically we're saying, based upon the average inventory, how many times did you turn that over? And keeping your inventory fresh is critically important. Customers like fresh inventory, they like new things. Things that aren't hanging around for a long time create a greater sense of urgency in customers. So inventory turnover is a critical metric.
The second metric is gross margin return on investment and that's a little bit more involved, but it really answers a basic question; how many gross margin dollars, which we just talked about, did the inventory investment generate during the year to pay all of the other business expenses? Here's where inventory turn combines with the margin percentage. The basic calculation that I like to use, I like to state it in terms of dollars, is take the total gross margin dollars that were generated for the year and divide that by the average inventory value. And basically what it's saying is if I had a dollar of average inventory during the course of the year how many gross margin dollars did that generate for me in return? It's a critical measure of how well that inventory is performing. Again, we started out the program by saying that inventory for an ecommerce retailer is the critical active asset and so now we're measuring how well that active asset performed during the course of the year.
CM: Ted, thank you so much. Do you have any final thoughts on inventory productivity that you'd like to go over?
TH: I guess I would just leave with the concept that once you measure what your metric is, how you're doing in turnover, how you're doing in GMROI, there's no such thing as standing still. If you don't know that you're moving forward, then most likely you're going backwards and it's always important to be moving forward.
CM: That's a great comment. That is our time today with Ted Hurlbut of HurlbutAssociates.com. Ted, thank you so much for being here.
TH: Thank you.